PIMCO is out with its secular outlook for the UK. PIMCO Portfolio Manager and EVP Michael Amey comments on growth and inflation and their effect on UK assets in the new normal of deleveraging, greater regulation and de-globalisation. One comment he made on default risk was quite informative:

Q: PIMCO has identified sovereign risk as a key theme for 2010. How significant is this risk for the UK relative to the eurozone?

Amey: Sovereign risk is a key risk for the UK but in a slightly different way to the economies of continental Europe. The UK government deficit, which is currently running at around 11% of GDP, is one of the highest both on record and within the developed world. That creates a potential risk as regards to the ability of the government to finance its debt. However, unlike countries within the eurozone, the UK has the advantage of an independent floating currency, making it highly unlikely it will suffer the problems currently besetting parts of the eurozone. With its own currency, the UK will always have the ability to repay its debts, but it may devalue the debt in real terms when viewed in non- GBP terms. Therefore, UK sovereign debt risk will continue to be an issue as long as UK debt levels remain high, which in turn will put pressure on the currency and the inflation rate, and potentially erode the longer-term value of government debt. [underlining added]

The UK government is a sovereign with substantially all of its debts in a currency it creates. It cannot face an involuntary solvency crisis any more than Japan or the United States. This is quite a bit different than Spain, Greece or Portugal for example where national solvency is an issue in the medium-term.

Notice how low Japanese, US and UK interest rates are despite enormous budget deficits in this chart from the FT.

When you hear pundits talking about national insolvency for the UK or the US, it’s absolute rubbish. As Amey says, the risks are inflation and currency losses not losses in principal.

The full Q&A is a good read if you have British-based investments and is available via the link below.

Update: Note that Amey’s colleague Andrew Balls says that these differences between the Eurozone and sovereign debtors like the UK or US mean PIMCO would not favour Bunds over Treasuries.

We will look both within and beyond Europe for higher-quality securities where we think we can achieve similar or superior risk-adjusted returns. We remain positive on core duration and German bunds. But given the potential for eurozone governments or the ECB to be drawn deeper and deeper into providing support, we do not see German bunds as offering significant advantages over the secular horizon compared with U.S. Treasuries.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

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22 Comments

1. The UK has guaranteed its banking system which is significantly short USDs
2. This analysis overlooks the potential for a crisis of confidence where no one — foreign or domestic — wants to risk holding their assets in GBP for any length of time. There are many examples of this; ultimately trade cannot respond as quickly as currency trading
3. If you want to analyse UK sovereign debt, you need to begin with the off balance sheet PPPs instead of reported figures

Time will be the ultimate arbiter of the debate about solvency and UK
sovereign risk. You can make your arguments about default but ultimately
it’s how the asset classes perfrom that make the difference for an investor.

I do agree with the original point that UK sovereign debt bears no default risk, just thought I would skip ahead to elaborate how and why it’s the result of risk shifting and not risk reduction as there is no underlying transformative action taken by issuing own-currency debt

I’d be interested in how “risk shifting” creates greater solvency risk. The
PPI off balance sheet activities probably do vastly understate government
borrowing, but from what I understand, these are all sterling denominated
transactions. If not, then I could definitely appreciate the solvency
risk, but not if they are sterling liabilities ultimately assumed by the
government. Credit or fiat money systems cannot be analyzed as if they were
commodity money systems, and conventional economics still does not get that. In
fact, assumption of a gold standard lurks behind many parts of
contemporary mainstream economics, including the view that governments are somehow
budget constrained, as illustrated by the commentary underlying the recent UK
budget. Problems would only arise if a large portion of the UK’s debt was
foreign currency denominated, as was the case for the Asian NIEs in the
1997/98 financial crisis.
In a country with a currency that is not convertible upon demand into
anything other than itself (no gold “backing”, no fixed exchange rate), the
government can never run out of money to spend, nor does it need to acquire
money from the private sector in order to spend. This does not mean the
government doesn’t face the risk of inflation, currency depreciation, or capital
flight as a result of shifting private sector portfolio preferences, but
the budget constraint on the government, the monopoly supplier of currency,
may be different than we have been taught from classical economics, which
is largely predicated on the notion of a now non-existent gold standard. The
UK Treasury cuts you a benefits cheque, your checking account gets
credited, and then some reserves get moved around on the Bank of England’s balance
sheet and on bank balance sheets to enable the central bank (in this case,
the Bank of England) to hit its interest rate target. If anything, some
inflation would probably be a good thing right now, given the prevailing high
levels of private sector debt and the deflationary risk that PRIVATE debt
represents because of the natural constraints against income and assets
which operate here.

I do agree with the original point that UK sovereign debt bears no default
risk, just thought I would skip ahead to elaborate how and why it’s the
result of risk shifting and not risk reduction as there is no underlying
transformative action taken by issuing own-currency debt

History is full of examples of bankruptcies of national sovereigns who had their own currency. It is accepted wisdom that it can’t occur but history seems to be littered with examples of it occurring and sovereign nations choosing this option. Argentina recently. Mexico would have done it in the 80s if it wasn’t for U.S. essentially bailing them out. Maybe I am missing something but history doesn’t support that principal is 100% safe just because you can print your own currency.

You are missing the foreign debt that both nations had. If a country has
substantially all of its debts in a fiat currency it creates it is a
different story. I have written on both Russian and Argentina in the past
and it was the foreign obligations which created the problem in each case.

Ed is completely correct on this. Foreign (or non-sovereign) debt acts an external constraint in a way that debt in the country’s own free-floating non-convertible domestic debt does not.
In the specific case of the UK, the relevant question is the extent of the non-sterling denominated debt. The size of the sterling debt is irrelevant as far as national solvency issues go.

That was my point in the Taleb post as well. The Weimar canard is pure political posturing from those that share my anti-inflation bias. But, it is deceitful because others who do not understand what the true origins of hyperinflation buy into this kind of thing. Let’s leave it at “inflation depreciates the value of my currency assets and I don’t want that.”Of course, given the massive amounts of debt in the system, there aren’t a lot of choices left.

“Russia defaulted voluntarily, an event which the geniuses at Long-Term Capital Management failed to model correctly. Moreover, the immediate stress on Russia was not the rouble-denominated debt but the mountain of foreign currency obligations via an unrealistic currency peg which were draining reserves. Similar events unfolded in Argentina a few years later as their currency board crumbled and the Peso was devalued by three-quarters.”

Ed & Marshall, I think it is apparent to most people that governments who issue debt in their own currencies will most likely choose not to outright default on their debt, but would rather monetize the debt through central bank purchases, i.e. money printing. The problem I have with this is that if the situation is dire, default via money printing is not a panacea. As the markets understand what is happening, i.e. holders of currency and debt, the host country could be cut off rrom the capital markets. So the outstanding obligations could be inflated away, but future funding of the government would eventually be lost and currency completely unacceptable as a form of trade. from that standpoint it matters not whether debts are denominated in their own currency or not. So, I’m a little lost as to why you would think a government such as the U.S. is never revenue constrained and can never default. That is true until such time as people stop accepting the currency as payment.

I would call the inflation route default by inflation – and this is essentially what the UK did after the second world war. But, Marshall would take me to task for this politicizing of the issue. The fact is that default by inflation is not really default in the real world; after all, we have had a massive depreciation in the currency since the Fed was inaugurated already.

At a minimum, inflation is legalized theft by the Fed, counterfeiting if you will. But again that’s my own very anti-inflation and political view (which many share with me, I should add).

If you want to talk about monetizing debt, the Fed could reasonably buy any debt the US government issues if it so chose. It could manipulate prices down to whatever rate it so chose in extreme circumstances. We’re talking about fiat currency here. Again, the government is not constrained in repaying in a currency it creates by bond vigilantes or anyone else except taxpayers. People really fail to understand this. There’s nothing stopping the Fed from buying up long-term treasuries except that it would expose its vaunted independence as a fraud. The government is free to do as it wishes absent a tax revolt if a currency is only backed by its taxing power. The reason that gold bugs want gold-backing is for this very reason.

Let me just say that I think one has to distinguish between default in the classic sense of having one’s cheques bounce (or refusing to pay one’s bills) and inflation. You can’t cash in on a credit default swap by virtue of running a positive rate of inflation, which the UK is running today (+3%) so it’s not default in that sense.
Obviously, if you debase a currency sufficiently then it feels like that to an investor, but I still think the UK going all Weimar on us is still unlikely in the current scenario.

“When you hear pundits talking about national insolvency for the UK or the US, it’s absolute rubbish.”

I love to battle against these types of statements Ed. This is so close to the statement that the “identity says it must be so so it must be so. Deal with it.”. I’ve seen a lot of this today on blogs. Who cares about the difference between default or printing money when we cannot sustain lifestyles? It’s moot. We’re not economists and all we know is that there is a chance that we may all get less than we want. That’s life, but whether or not it’s default or printing, it may mean we lose a bit of our share.

Theoretically, the ability to print money to pay debts does nothing to make us richer. Keynes was about countering capital markets to prevent damage that could be prevented because we are to stupid to look two steps forward when we need to pay our bills now. It’s not about the ability to pay our nominal debts forever. It’s about bridging the gap. Just ’cause we cannot default does not mean we cannot suffer and your argument sucks because it insinuates that because we cannot default we will not suffer.

Just finished Minskey, and what do you know, he was for a smaller government than we have now.

Scott, you are obviously reading into my comments more than is there. My argument does not ‘suck.’ I am making a factual statement about default risk in differentiating between users and creators of currency.

As to my views on inflation, had you taken the time to read the comments before you posted your own, you would see that our viewpoints do not differ substantially. This is what I have already said:

“I would call the inflation route default by inflation – and this is essentially what the UK did after the second world war. But, Marshall would take me to task for this politicizing of the issue. The fact is that default by inflation is not really default in the real world; after all, we have had a massive depreciation in the currency since the Fed was inaugurated already.

At a minimum, inflation is legalized theft by the Fed, counterfeiting if you will. But again that’s my own very anti-inflation and political view (which many share with me, I should add).”

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